By Emin Aboolian, senior vice president of underwriting, iBorrow
It is not a shock to anyone in the industry to say that the commercial real estate market this year has been challenging and expected to experience further turbulence.
The hoped-for interest rate cuts from the Federal Reserve have not yet happened. Price expectations from sellers have remained too optimistic due to the historic low interest rate environment that defined the capital markets for more than a decade. Investors with robust capital buckets continue to sit on the sidelines waiting for price corrections. The wall of impending maturities keeps getting closer — and seemingly larger.
The “extend and pretend” approach from large lenders has pushed some maturities out but has not addressed the underlying debt-to-income ratios that these struggling commercial properties face. In summary, no matter what segment you are in — retail, office, industrial or multifamily — 2024 has been a tough year so far and is expected to carry into 2025 until sellers are forced to transact.
So why do we think these clouds are going to clear generally, with the Texas market in particular pulling ahead in its recovery? Broadly speaking, the real estate sector is a victim of its own success and excess from the era of ultra-low interest rates. But what that means for the future is that areas in the country that continue to see economic growth, population growth and positive business environments will see advantages moving into the second half of 2024 and into 2025.
There are three reasons to hold this perspective. One, the bottom of the market seems to be near, if not already here. Two, tame inflation will encourage the Fed to finally drop interest rates. And three, there is substantial dry powder available in private credit and non-bank lending markets such that as the market loosens, liquidity will be available for strong borrowers — even if the banks do not rush back in.
Approaching the Bottom
The Texas office real estate market is dominated by its two largest metros, the Dallas-Fort Worth metroplex and the Houston sprawl with its strength in energy and oil. A quick look at what has been happening in these metros gives a pretty good sense that the recovery of even the hardest-hit office sector seems possible.
According to CBRE and Colliers second-quarter market reports, net absorption of office space is still negative in both Houston and Dallas, but Houston saw an improvement over the first quarter of 2024. The pace of new deliveries and new construction starts in both cities has slowed, reducing pressure on overcapacity.
Asking rents, meanwhile, remain stable across Class A properties, as leasing activity begins to pick up, particularly for larger deals of more than 10,000 square feet. The flight-to-quality trend continues to impact Class B properties as tenants seek less space in well-equipped Class A buildings. All this points to a likely stabilization of the office market, mostly in the Class A space, and that is a good sign for what needs to come next: proper valuations to drive increased sales and consistent cashflows to allow for refinancings.
Interest Rates Will Accelerate Trends
As economic data comes in across the country, the inflation tsunami that occurred post-COVID is finally receding. Core CPI is almost back to the Fed target, dropping 0.1 percent in June and to 3 percent for the past 12 months, and key metrics like wage growth and employment remain strong but not overheated. As the Fed looks to manage its two responsibilities — economic growth and inflation — a 25- to 75-basis-point decrease in the federal funds rate through the year end looks reasonable.
Though not the (near) zero interest rate of 2021, most market participants have recalibrated their expectations and will take advantage of any rate decrease. The drop will drive strong Class A properties facing impending maturities to capitalize on their leasing trends and refinance. Those owners who are ready to exit after the past couple of years will sell as investors return to the market. The rate environment could encourage better pricing, but most sellers will likely be distressed, and investors will want discounts.
Liquidity Will Return, Led by Non-Bank Participants
Into the second quarter, the Dallas Fed has reported a marked change in lending conditions for commercial real estate, with the loan volume index increase to 5.8 in June from negative 4.6 in May, with over one third of banks reporting increased lending. Only 11.6 percent of banks reported tightening their credit, while 88.4 percent reported no change.
As top-line rates come down and the economics of properties stabilize, borrowers will continue to see improvement in access to capital from banks. However, given the overall scrutiny of commercial banks and their real estate lending portfolios, bank lending is more likely to be second to alternative sources of capital like private lenders and credit providers (like iBorrow).
Private credit managers globally are sitting on a nearly $1.5 trillion pile of cash. Contrary to any fear of a lack of capital available for investment, there is substantial dry powder. These fund managers want opportunities to deploy their cash. They will be looking specifically to regions like Texas where economic growth continues and employment and population trends favor commercial real estate — not just in office but also in multifamily, industrial and retail.
The broad office market will still take time to recover, but the bright spots in prime Class A office buildings will shine in the second half of 2024. Multifamily, including affordable and workforce housing, will continue to be needed as more people move to Texas. Retail has remained surprisingly resilient post-pandemic, and industrial, as the e-commerce transition and “last-mile logistics” puts a heavy burden on this rapidly expanding property class.
Now is the time to take a closer look at tapping private credit, as either a borrower or as an investor, because opportunities will abound through the second half of 2024 and for the next few years.
iBorrow is a nationwide direct lender that provides short-term bridge financing to commercial and multifamily owners.